The price of a single family home is determined through comps, what other similar homes in the area are selling for. Commercial real estate is different in that properties are priced exclusively on the income stream they generate. We are now going to discuss both how commercial real estate is valued and what is actually taking place in the market using a simple example told through a story.
Bob owns a retail strip with five stores. The year is 2007. Business is great and all five of his stores are occupied. His five tenants are Harry's Hardware, Nancy's Nails, Tina's Tanning, Carl's Cuts, and Arnold's ABC.
Bob charges each retail store $3,333 per month or $40,000 per year in rent. That means he collects $200,000 per year in total income. His annual expenses to run the retail strip are $100,000 per year (average retail expenses run about 30% of total revenue, but we'll say Bob is not an efficient manager to keep the numbers simple).
$200,000 Annual Income
$100,000 Annual Expenses
$100,000 Net Operating Income
The net operating income includes all expenses other than his monthly mortgage payments on the building. The NOI is the basis point used to determine every commercial building price in the country.
If Bob decides to sell the retail strip, the final price will be determined based on how much an investor is willing to pay to receive this annual income stream.
Meet Mike. He is a 45 year old successful business owner that is looking to make an investment in a commercial property building.
Mike calls his real estate agent and says he is tired of the low interest rates he receives holding money in cash or bonds, and the stock market makes him nervous. He is interested in purchasing a building but he wants to make sure he is paid well for the risk he takes buying a property. He wants a 10% return on his money every year.
Okay, so how much will Mike be willing to offer Bob for his $100,000 annual income stream (Net Operating Income)?
$100,000 / .10 = $1,000,000
Mike would offer Bob $1 million for his building to receive his 10% return. You can use this formula to determine either the cap rate or purchase price once you know a building's NOI.
Cap rates are what an investor is willing to pay for an income stream. They are determined based on the collective sentiment in the market. If investors feel that commercial real estate prices are risky, they will demand a higher return to purchase the property. What if Mike was demanding a 15% return on his investment because he was worried about the retail sector moving forward? What happens to the purchase price?
$100,000 / .15 = $666,667 Purchase Price
What if Mike felt that the worst of the economy was behind us and that the retail sector was going to be extremely strong in the future? He may be willing to purchase the building with only a 7% return on his money. After all, he is getting less than 1% holding his cash in a bank CD. What happens to the purchase price now?
$100,000 / .07 = $1,428,571
There are two ways that properties can increase or decrease in value. The first we just discussed which is the sentiment (cap rates) toward properties rising or falling. The second would be the increase (or decrease) of the Net Operating Income. The NOI can be raised by either increasing income (raising rents) or decreasing expenses (better management).
Let's say that in Bob’s retail center, Harry's Hardware has a lease that is expiring this year (2007). This allows Bob the opportunity to negotiate new lease terms. Harry's business has been doing excellent and he has no desire to leave the location. Bob tells Harry that he needs to raise his rent up to $5,000 per month, or an increase of $20,000 per year. Harry agrees.
In addition, Bob has found a way to cut out $30,000 per year in annual expenses. So what does his NOI look like now?
$220,000 Annual Income
$70,000 Annual Expenses
If Mike now approaches Bob’s building looking for a 10% return (cap rate), what is his new purchase price?
$150,000 / .10 = $1,500,000
Bob’s property has increased in value by $500,000 with a simple rent increase and better property management with no increase in cap rates in his area.
This simple example shows you the incredible opportunity commercial real estate offers as an investment vehicle. Before we discuss further how and when we can take advantage of this opportunity, we must first look at where we are in the current market cycle and where we are going in the future.
We will do this though the eyes of our friend, Bob.